Monetary Policy 101

Monetary policy is the set of policy actions that central banks use to achieve their legal mandates. Most central banks function under legislative mandates that focus on two basic objectives:

• Promoting price stability (a.k.a. restraining inflation)
• Promoting sustainable economic growth, sometimes with an explicit goal of promoting maximum employment

Although it's a no-brainer that promoting economic growth is more important to those of us who work for a living, central bankers like to focus primarily on inflation. Low inflation fosters stable business and investment environments, so central bankers see it as the best way to promote long-run economic growth. Low inflation is also an end in itself because high inflation erodes assets and undermines capital accumulation. Some central banks, such as the European Central Bank (ECB), have only one mandate - to ensure price stability - with other policy objectives (growth and employment) explicitly relegated to secondary status. Still other central banks - the Swiss National Bank, for example - have a mandate to ensure a stable currency, though most countries have delegated that responsibility to the national finance ministry/treasury department.

Looking at benchmark interest rates

The primary lever of monetary policy is changes to benchmark interest rates, such as the federal funds rate in the United States or the refinance rate in the Eurozone. Changes in interest rates effectively amount to changes in the cost of money, where higher interest rates increase the cost of borrowing and lower interest rates reduce the cost of borrowing. The benchmark rates set by central banks apply to the nation's banking system and determine the cost of borrowing between banks. Banks in turn adjust the interest rates they charge to firms and individual borrowers based on these benchmark rates, affecting domestic retail borrowing costs. Other tools in the monetary policy toolkit used by central bankers are

• Changes to money supply: The overall amount of money in circulation, or the greater the money supply, the lower the cost
• Reserve requirements: The amount of capital required to be-set aside by the banking system; money that cannot be used for lending

Easy money, tight money

The main thrust (or bias, as markets call it) of monetary policy generally falls into two categories: expansionary and restrictive. An expansionary monetary policy aims to expand or stimulate economic growth, while a restrictive bias aims to slow economic growth, usually to fight off inflation.

Expansionary monetary policy

Expansionary monetary policy (also know as accommodative or stimulative monetary policy) is typically achieved through lowering interest rates (that is, reducing the costs of borrowing in the hope of spurring investment and consumer spending). Cutting interest rates is also known as easing interest rates and is frequently summed up in the term easy monetary policy. Central banks can also increase the money supply - the overall quantity of money in the economy - which also works to lower borrowing costs. A reduction in the reserve requirement of banks frees up capital for lending, adding to the money supply and reducing borrowing costs as well.

An expansionary monetary policy is typically employed when economic growth is low, stagnant, or contracting, and unemployment is rising. An easier monetary policy can also be introduced in response to major shocks to the financial, economic system, such as that following the September 11, 2001, terror attacks in the United States or the bursting of Japan’s “Bubble Economy” in the early 1990s.

Restrictive monetary policy

Restrictive monetary policy (also known as contractionary or tighter monetary policy) is achieved by raising, or “tightening,” interest rates. Higher interest rates increase the cost of borrowing, and work to reduce spending and investment with the aim of slowing economic growth.

Central banks typically employ a tighter monetary policy when an economy is believed to be expanding too rapidly. The tear from the central banker‘s perspective is that heightened demand coupled with the low cost of borrowing may lead to inflation beyond levels considered acceptable to the long-run health of an economy. With too much money chasing the same or too few goods, prices begin to rise, and inflation rears its ugly head. Rapid wage gains, for example, may lead to increased personal consumption, driving up the cost of all manner of retail products.